Massive World Events Deliver Little Market Impact


 

It was a relatively quiet month for the capital markets as the S&P/TSX and the S&P 500 lost 0.1% while the Dow gained 0.8%.

Not that there wasn’t a lot going on in the World – far from it.

Take your pick of potential market disruptors: political unrest and civil war in the Middle East and North Africa; the earthquake, tsunami, nuclear disaster triple play in Japan; inflation concerns in the emerging economies; sovereign debt issues in Europe; budget battles in the U.S. and the scheduled conclusion of the QE2 program.

Have we forgotten anything?  Oh yeah, surging oil prices.

How big a threat does the turmoil in the MENA (Middle East/North Africa) present?

At the moment, not much.  With the exception of Libya, oil continues to flow out of the region and the increase in crude prices is mainly due to stronger global demand.  Sure there is probably a five-to-ten-dollar-a-barrel risk premium being tacked on to oil prices due to the current crisis, but this is mainly to reflect the potential risk of the situation deteriorating and spreading to other countries in the region.

Apart from oil, most MENA countries have relatively little impact on the global economy. Bahrain (where the U.S. 5th fleet calls home) and Saudi Arabia are the real concerns, and so far these counties look to have stabilized.  Of course the crisis is still in the process of playing out and we really don’t know what the ultimate political landscape in the region will look like.

A broad move towards democratic rule (including in Iran) would be a good thing.  Apart from oil, these counties have very little going for them economically and need to get more in step with the global economy.  Of course, a Western-oriented democratic government is only one of the many possibilities.  An autocratic Islamic government is also possible and would be extremely negative.  The problem is that we just don’t know who the players are.  We hope someone does.

Japan is different.

The nation’s disaster triple play will likely have a much larger impact on the global economy in the short term.

You don’t take World’s third largest economy off the grid for an indefinite period of time and not have it impact Global economic growth.  Supply-chain disruptions are inevitable as many countries count on Japan as a valuable trading partner.

Rebuilding destroyed housing and replacing tainted food stocks will also add to global inflationary pressures, not to mention higher future oil demand to replace nuclear power plants that may never be restarted.  Luckily, if there is one country in the World able to cope with the magnitude of a disaster such as this, it is Japan.

Yes, they have too much government debt and will need to take on more debt to rebuild destroyed infrastructure, but this added spending could actually help spur economic growth and help galvanize political support for the government to do more to help the economy out of its deflationary funk.

Barring a turn for the worst at the Fukushima nuclear plant, Japan will rebuild and the impact to the Global economy will be counted in months, not years.

While a little inflation in Japan might actually be good thing, the same cannot be said for the rest of Asia where inflation is becoming a major threat to economic growth.

What about China?

Sure, turmoil in the Middle East has led to higher oil prices and bad weather has resulted in increased food costs, but increased demand is also playing a significant role.  Unlike economies of the developed World, developing economies have recovered from the financial crisis and their output gap is now virtually non-existent.

Low-cost labour, once an abundant commodity, is becoming scarce and wage inflation is on the rise.  Growth is important for emerging countries such as China, but Chinese leaders are painfully aware that higher prices are behind much of the political unrest in the Middle East and have also historically played a large role in episodes of political unrest in China; case in point: Tiananmen Square in 1989.

In early April, China raised interest rates for the fourth time in less than six months.  Given that deposit rates are still lower than inflation, we wouldn’t be surprised if more increases are on the way.  It’s a dangerous game, however.  China is seen as the engine of growth for the World and a slow-down in Chinese growth would be received poorly by the capital markets, especially those heavily exposed to commodities, like Canada.

 

Interestingly, the developing world is not the only one raising interest rates.

On April 7, the European Central Bank raised interest rates for the first time since 2008.  While the hike was a modest 25 basis points, they also signaled more increases were in the cards.

The increase was widely expected, though the timing was curious given Portugal was in the process of seeking a bailout rumored in the neighborhood of €80-billion.  The ECB is hoping Portugal will be the last chapter in the debt crisis; however one suspects that a sequel, or even a mini-series, might be in the works.

Many still believe a restructuring of Irish and Greek debt is inevitable.  The big fear, of course, is that bond vigilantes will now turn their focus on Spain, which might prove too big to bail

We understand the motivation for the rate increase, given Euro-zone inflation hit 2.6% in March and is above the ECB’s upper target range, but apart from maybe Germany, their economy is hardly robust.  The risk is that by raising rates prematurely, the ECB could snuff out any economic recovery that maybe taking place.

Given Europe’s past experience with inflation (Germany after WWI), they would rather risk recession than let inflation get out of control.

The U.S. Federal Reserve is following a different path.

Deflation is a bigger concern in America and they would risk a little inflation in order to prevent deflation.

With an increase in overnight interest rates probably out of the question until at least next year, the near-term question is: what happens when the current quantitative easing program ends in June?

The fear is that not having the Federal Reserves in the market buying government debt will result in a decline in demand and an increase in yields.  Others, however, believe rates could actually decline as concerns over the inflationary consequences related with quantitative easing recedes.  Many also believe the true goal of QE2 was less about keeping interest rates low and more about getting asset prices and consumer net worth higher in order to spur retail spending.

The last thing the Fed wanted was a falling stock market and a weak housing market at the same time.  If this is the case, how will the equity markets react to the end of QE2?  We suspect, not well.

The Fed doesn’t need to raise interest rates in order to signal that they are moving towards a tighter monetary policy environment.

Not only could the U.S. be on the verge of a tighter monetary policy, but fiscal policy could also be turning against consumers in the near future.

The Republicans have been aggressively pushing for greater spending cuts and lower government deficits.  A government shut-down was narrowly averted in early April when Democrats managed to reach a compromise with House of Representative Republicans to approve the fiscal 2011 budget.

Even though there are only has six months left in fiscal 2011, a failure to reach a deal would have resulted in many government agencies temporarily closing up shop.

Republicans wanted cuts of $61-billion.  Democrats originally wanted an increase of $40-billion, but offered $33-billion and finally agreed on $38.5-billion.  Next up is the Federal debt ceiling, which by current law is not allowed to exceed $14.294-trillion.  Since current Federal U.S. Government debt is only $81-billion below this limit and predicted to reach the ceiling no later than May 16th, the U.S. will likely default if Congress does not agree to increase the ceiling.

Again, the Republicans are holding out for more spending cuts.  In the end, a deal will be made and default will be averted, but it’s going to be a lot of fun to watch in the meantime.

The good news is all this negotiation is bringing to the forefront much needed debate over the unsustainable path U.S. government spending and debt is on.  Don’t expect any quick solutions, however.  Both sides are still miles apart and deficit reduction is likely to be the dominant issue during the 2012 election.

The U.S. Economy

 

Stronger net exports have been one of the biggest drivers of the recovery and the main reason for the strength in the manufacturing sector in the U.S.

Q4 2010 GDP was revised back up to 3.1% from 2.8% previously with exports coming in a little stronger.  A recent KPMG survey found 65% of U.S. manufacturing executives expect revenue to rise in the next 12 months, versus only 57% of service-sector executives.  Manufacturing executives also plan to hire more workers, with 41% expecting employment at their firms to increase over the next 12 months versus only 28% at service-sector companies.

That’s the good news.  The bad news is that Q1 growth is looking a bit sluggish with most expecting only 2% growth.  Slower consumer spending due to higher costs (blame oil and the weather) and the as-yet-unknown fallout from the disaster in Japan are cited as the main reasons.

Another good month for employment growth in the U.S.  with 201,000 new jobs created and the unemployment rate dropping to 8.8%, its lowest level since March 2009.

Unlike past months, the decline in the unemployment rate was entirely due to more jobs as the labour force increased by 160,000.  Manufacturing, retail, leisure & hospitality, and education all reported solid new job growth while construction and local government reported a decline in jobs.  Private sector employment increased by 230,000 and an additional 29,000 temporary jobs were created, a good sign given many of these could eventually turn into permanent jobs.

The only negative during the month is that wage growth remains non-existent, prompting Gluskin Sheff Chief Economist David Rosenberg to state the U.S. is experiencing not a jobless recovery, but a wage-less recovery.

While inflation in the U.S. is not as high as it is in Europe or the developing economies, it continues to creep higher.

Energy is the big culprit, while food prices have leveled off but show no sign of decreasing anytime soon.  Housing is a large weight in the CPI basket of goods and is calculated by estimating the equivalent rent homeowners would have to pay and is not based on the increase or decrease in home prices.  With vacancies decreasing and rental costs on the rise, housing could become a major factor in moving CPI higher in the coming months.

Despite the increase in inflation, the Federal Reserve is not concerned.  While they acknowledge inflation has moved higher, they believe the increase is due to higher commodity prices and is “transitory.”  As mentioned above, wage inflation is non-existent and long-term inflationary expectation should remain in check as long as the recovery is of the wage-less variety.  At least this is what the Federal Reserve is betting.


There is certainly enough going on in the world to worry consumers and justify the slide in consumer confidence, though higher energy prices probably top the list.   A recent RBC Capital survey found 32% of consumers had reduced discretionary spending because of higher gasoline prices.

Despite the weak Consumer Confidence indicators, the consumer was actually quite active in February, and March is looking pretty decent as well.  While same store sales increases in the 2% range might not seem that strong, they were up against increases of around 9% last year.

Also detracting from March retail sales is the fact Easter falls on April 24th this year versus April 4th last year.  This will be the latest Easter since 1943 and means not only has it been a freaking long time since we’ve had a holiday (New Year’s Day was our last holiday?  Ridiculous.  What happened to that Hockey Day idea?), but Easter spending is likely to be pushed into April rather than taking place in March.  Surprisingly, Easter is the third largest selling season after Christmas and Valentine’s Day.  Who knew?

Given the relatively strong retail sales, it’s not surprising to find consumer deleveraging has been put on the back burner.  While revolving debt (which does not have a fixed number of payments and is comprised largely of credit card debt) declined $2.7-billion in February, non-revolving debt soared $10.3-billion as consumers loaded up on big ticket items like new automobiles.

Total household debt, which includes mortgages, declined in 2010 to $13.4-trillion – or 116% of disposable income – versus a peak of 130% in 2007.  Unfortunately, it is estimated that over half of the $208.8-billion decline was the result of borrowers reneging on their debts.  Now they are starting to borrow even more money.  And who can blame them given real interest rates are almost negative (assuming nominal rates are less than inflation)?  They are being paid to borrow.

We are becoming wary of the deleveraging story and the austerity kick U.S. consumers apparently were undertaking.  When people line up in order to buy the latest electronic gadget, we become concerned that we have returned to the consumer-led economy of old.

If low interest rates benefit the consumer and entice them to spend, who loses? 

Why savers, of course.  A good financial planner will tell you that in order to retire comfortably, you need to work hard, stay out of debt and maintain a disciplined saving plan.  By keeping interest rates artificially low, the government is actually punishing these model citizens in order to help those that over-extended and risk losing their homes.

The U.S. Labor Department estimates that in 2009, investment income for the nearly 25 million households headed by people over 65 declined 34% from 2007 to its lowest level since 2003.  Even worse, the Employee Research Institute estimates a third of retirees had to deplete a greater-than-expected amount of their capital in 2010 just to meet basic living expenses.

Shameful.  No wonder the government is scared to death of reforming Social Security.

The only good thing that can be said about the housing market is prices are falling to levels where even the most prudent of fence sitters will be enticed to enter the market, if they can get a mortgage that is.

It’s a buyer’s market.

The only market that is looking better is the rental market.  With home ownership rates heading down and driving more people into the rental market, vacancy rates are plunging and rents are headed higher.  Property-research firm Reis estimates the average U.S. vacancy rate declined to 6.6% in 2010 from 8% in 2009.

Higher oil prices again helped inflate U.S. imports and resulted in the trade deficit increasing nearly 15% in January.

Exports also recorded a healthy increase and have been a major contributor to U.S. economic recovery.  The Commerce Department estimates exports accounted for almost half of the economy’s 3.0% growth during the recent recovery.

While the U.S. is not generally considered a big trading nation with most goods produced in the U.S. consumed in the U.S., exports currently comprise nearly 13% of U.S. GDP versus only 10% 10 years ago, the highest level since data began being collected in 1929. With China, the World’s second largest economy, desperately trying to contain inflation and Japan, the World’s third largest economy, reeling from the earthquake, tsunami and nuclear disaster, there are big questions how the World’s largest economy will fair.

The Canadian Economy

January followed up December’s strong growth in GDP with an equally robust 0.5% increase.

Over the past three months, Canadian GDP has increased at an annualized 4.6% clip.  The OECD (Organization for Economic Co-operation and Development) believes this pace can be maintained and Canada will in fact lead the G7 in growth in the first and second quarters this year.  They estimate GDP grew 5.2% in Q1 and will grow 3.8% in Q2.

While the OECD didn’t specifically mention why they believe Canada will out-grow their G7 counterparts, exposure to the strong commodity markets would seem the most likely.  Unfortunately, the strong Canadian dollar might reduce some of this optimism.

While March employment headlines may have been negative with Canada losing jobs for the first time in six months (though only 1,500), the reality was somewhat more positive.

Canada offset the loss of 92,000 part time jobs with the creation of 90,600 new full time jobs, a trade we would take anytime.   Even better, the unemployment rate fell to 7.7% as the labour force contracted by 15,000.

While the Canadian job market has brightened considerably over the past year, Canadian Labour Congress economist Sylvain Schetagne believes we are still well short of a full recovery.  Despite the number of new full time jobs created in March, Mr. Schetagne contends the quality of recent job gains has been generally poor with a greater percentage of workers forced to take temporary and part time jobs compared to pre-recession levels.

The unemployment rate has moved lower, but is still above the 6.2% level of October 2008 and there are still 30% more unemployed workers compared to October 2008.  We think Mr. Schetagne must be a glass half empty kind of guy.

February saw similar trends as last month; headline inflation remains over 2%, but core inflation moved a bit lower and is still comfortably lower than the Bank of Canada’s 2% upper threshold.

Bank of Canada Governor Mark Carney believes inflation is now a greater risk than deflation, and inflationary risks are being telegraphed by the bond market.  The Conference Board of Canada believes increased food prices could remain high for the foreseeable future as factors driving price increases are structural.

Fortunately, the strong Canadian dollar has helped dull some of the pain.  If not for the dollar and the upcoming Federal election, the Bank of Canada would be raising interest rates.  Higher rates are on the way.  You have been warned!

Retail sales in January, while still up strongly over last year, was down versus December.

Given lower consumer confidence numbers in March, retail sales could be softening even further.  Higher oil prices and turmoil in the Middle East and North Africa seem to be darkening the Canadian consumer’s outlook.

The Canadian housing market continues to be a model of health compared to what’s happening in the U.S.

The average resale price in Canada is 80% higher than in the U.S. and moving higher every month.  How long can this continue?  Is the Canadian market in a bubble with Canadian homeowners destined to end up like their U.S. counterparts?  Capital Economics economist David Madani certainly thinks some kind of correction is in order with homes selling for 5.5 times disposable income per worker, versus 3.5 times historically.

Mr. Madami believes house prices could fall 25% over the next three years.  This doesn’t seem to be a stretch given that prices are up over 100% since 1999.  By comparison, prices in the U.S. increased only 58% between 1999 and 2006 before the bubble burst.

Canada managed to eke out a small surplus in January as imports reached their highest level since 2008 while export growth was more restrained.  The strong Canadian dollar should ensure that this trend is maintained over the next few months.

With the exception of weaker consumer spending and concerns over an over-heating housing sector, there is a lot going right in Canada, especially compared to events taking place around the world.  So why are we headed back to the polls so soon?

What do you think of the economic impact of these world events?  Let us know in the comments below.